China's New Securities Law Being Put To Legal Test

Big four accounting firm Deloitte is being sued in a Shanghai court and being called before an administrative board in Beijing for having issued an unqualified audit opinion on a client with 'worrisome finances.'

The accusations are based on Deloitte's alleged failure to issue objective reports about publicly traded Kelon, which is one of China's 100 largest companies. The lawsuit against Deloitte is China's first investor-led lawsuit against an accounting firm, and it is also the first case involving public investors suing financial service providers under China's New Securities Law, which went into effect on Jan. 1, 2006.

Last year, former Kelon executives were accused of inflating sales and embezzling approximately $73 million. Kelon reported a $5.5 million net loss in 2004, after posting nearly $25 million in profits in 2003. Kelon managers have allegedly inflated profits since 2002 and violated securities laws. Deloitte was Kelon's auditor from 2002 through 2004, and though it qualified its audit opinion in both 2002 and 2003, it issued an unqualified opinion in 2004. Deloitte dropped Kelon as a client in 2004.

The lawsuit blames Deloitte for not disclosing the internal fraud in its audit. The New Securities Law and the Certified Public Accountant Law both require securities service institutions investigate the truth of the materials provided to them from publicly traded firms they audit. The New Securities Law seems to put the onus on the auditor to prevent misleading statements or material omissions in their opinion letters.

It is always interesting to see how a court handles a new law for the first time. In business cases of first impression, the Chinese courts often look to foreign law, particularly United States law, in interpreting their own business laws and the Shanghai court will likely do so here.

I previously blogged about how impressed I was with a United States Fortune 500 company that strictly adheres to United States environmental laws in building its retail sites in China:

This company's actions make sense because the odds are good that China's environmental laws and enforcement will get tougher over time, and building environmentally sound units now will almost certainly cost less than having to retrofit existing units a few years from now. On top of this, people often get very emotional about the environment, and I can see Chinese citizens getting very angry at a foreign company whose units in China are less environmentally sound than their units in the United States or elsewhere.

(Full post can be found here.)

The same holds true with respect to various business standards in China. Western firms would be wise to adhere to the stricter United States or European standards whenever feasible. The Chinese law and courts will likely eventually be getting every bit as strict as the United States, Canada, and Europe, and the standards China applies to foreign companies will always be at the high end in any event.

For additional reading on the Americanization of law around the world, check out this Yomiuri Shimbum article called the 'Americanization of International Law.'

Dan Harris founded the Harris & Moure in Seattle with the goal of creating an international law boutique to cater to small and medium sized businesses that operate internationally. He writes the China Law Blog; http://www.chinalawblog.com/. He spends about half his time on Chinese legal matters and the other half on international matters, usually involving Korea, Russia, or Vietnam. China is the fastest growing area in the firm. Harris can be reached at [email protected].

Big four accounting firm Deloitte is being sued in a Shanghai court and being called before an administrative board in Beijing for having issued an unqualified audit opinion on a client with 'worrisome finances.'

The accusations are based on Deloitte's alleged failure to issue objective reports about publicly traded Kelon, which is one of China's 100 largest companies. The lawsuit against Deloitte is China's first investor-led lawsuit against an accounting firm, and it is also the first case involving public investors suing financial service providers under China's New Securities Law, which went into effect on Jan. 1, 2006.

Last year, former Kelon executives were accused of inflating sales and embezzling approximately $73 million. Kelon reported a $5.5 million net loss in 2004, after posting nearly $25 million in profits in 2003. Kelon managers have allegedly inflated profits since 2002 and violated securities laws. Deloitte was Kelon's auditor from 2002 through 2004, and though it qualified its audit opinion in both 2002 and 2003, it issued an unqualified opinion in 2004. Deloitte dropped Kelon as a client in 2004.

The lawsuit blames Deloitte for not disclosing the internal fraud in its audit. The New Securities Law and the Certified Public Accountant Law both require securities service institutions investigate the truth of the materials provided to them from publicly traded firms they audit. The New Securities Law seems to put the onus on the auditor to prevent misleading statements or material omissions in their opinion letters.

It is always interesting to see how a court handles a new law for the first time. In business cases of first impression, the Chinese courts often look to foreign law, particularly United States law, in interpreting their own business laws and the Shanghai court will likely do so here.

I previously blogged about how impressed I was with a United States Fortune 500 company that strictly adheres to United States environmental laws in building its retail sites in China:

This company's actions make sense because the odds are good that China's environmental laws and enforcement will get tougher over time, and building environmentally sound units now will almost certainly cost less than having to retrofit existing units a few years from now. On top of this, people often get very emotional about the environment, and I can see Chinese citizens getting very angry at a foreign company whose units in China are less environmentally sound than their units in the United States or elsewhere.

(Full post can be found here.)

The same holds true with respect to various business standards in China. Western firms would be wise to adhere to the stricter United States or European standards whenever feasible. The Chinese law and courts will likely eventually be getting every bit as strict as the United States, Canada, and Europe, and the standards China applies to foreign companies will always be at the high end in any event.

For additional reading on the Americanization of law around the world, check out this Yomiuri Shimbum article called the 'Americanization of International Law.'

Dan Harris founded the Harris & Moure in Seattle with the goal of creating an international law boutique to cater to small and medium sized businesses that operate internationally. He writes the China Law Blog; http://www.chinalawblog.com/. He spends about half his time on Chinese legal matters and the other half on international matters, usually involving Korea, Russia, or Vietnam. China is the fastest growing area in the firm. Harris can be reached at [email protected].